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Understanding Term Loans

If you are having some cash-flow problems, consider a term loan. A term loan is a loan amount you can use for working capital, real estate, equipment or other small business needs. The amount typically available ranges from $25,000 to $200,000, and the loans usually carry a fixed interest rate and a set maturity date. You'll pay back the loan amount on a monthly or quarterly basis within a 1- to 10-year timeframe.

Term loans fall into one of two categories:

  • Intermediate-term loans. Term limits are typically less than three years. You'll use your cash flow to make monthly payments until the loan is paid off. Many immediate-term loans carry balloon payment requirements, so you could be forced to come up with a large sum of money to pay off the remainder of the loan. Intermediate loans are ideal for smaller purchases, such as computer or office equipment, furniture and for day-to-day operational expenses.
  • Long-term loans. Term limits are usually between 3 and 10 years, but some run as long as 20 years. Again, you'll use your cash flow to pay quarterly or monthly payments, or your bank could require that you set aside a percentage of your profits to cover the repayment. Your company's assets will be used as collateral, and often, the terms of the loan will prohibit you from taking on additional financial commitments—including employee salaries and other debts—during the term of the loan. The interest rates tend to be a few points lower than the interest rates on an intermediate loan. Long-term loans are ideal for real estate purchases, construction projects, business acquisitions or expensive equipment costs.

The process of applying for either type of term loan is pretty rigorous. If your business is established and you can prove that you have been financially successful for several years, you'll have a much easier time qualifying for a loan. On the contrary, if you're just starting your business or if you have been struggling to keep the business afloat, you likely won't qualify. You likely will have more luck applying for different types of business loans, such as those backed by the government or issued through lending networks.

When banks consider you for a term loan, they're going to want to see that you:

  1. Manage your business well. Where do you stand on current loans? Were you successful in repaying past loans? How long have you been in business? How well is the business being run?
  2. Aren't a risk. Your credit will be analyzed; your business financial statements will be reviewed, and your personal finances will be evaluated to assess whether you are a default risk.
  3. Have created a fail-proof business plan. Banks want to feel confident that your revenue projections are accurate and that you will be successful despite economic or industry conditions.
  4. Can offer collateral. This will usually be in the form of business assets; however, some banks will allow you to put your house or other personal assets up for collateral. Since the collateral insures that the bank receives its money back, the source must be worth more than what you borrow.
  5. Will liquidate your assets as needed. What assets can you convert to cash as an alternate repayment source?

If you meet the bank's criteria, term loans can be a cost-effective way to cover big purchases. Just be sure that the length of your loan term doesn't exceed the projected life of the items you are financing.

For example, computers and software typically need to be replaced or upgraded every three years. If you want to purchase that kind of equipment, don't take on a loan with payback terms for longer than three years. However, if you are purchasing a large piece of equipment for your manufacturing plant that you will actively use for 20 or more years, a term loan is a smart way to cover the cost of the item.

Finally, make sure to shop around to find the best rates. Banks want to work with successful businesses that can prove they aren't a risk, so you will have options.

 
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